Critics see regulatory capture in new LCR

Sid Verma
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Regulators fear a technical shortage of qualifying assets; Hopes grow for relaxation of other regulations

Global banks breathed a sigh of relief in January after the Basle Committee unveiled a landmark global liquidity rule that was more market friendly than expected, heralding a profound shift in the global bank-regulation push. Some now hope for further watering down of an array of new regulatory impositions yet to be finalized, including the net stable funding ratio (NSFR) and even additional capital buffers for systemically important and internationally active financial institutions.

The liquidity coverage ratio (LCR) is the first-ever attempt by regulators to introduce a global unified framework that ensures that banks possess a pool of ostensibly liquid assets for at least 30 days during a liquidity crisis, without recourse to central bank support.

Responding to the charge that regulators have underestimated the liquidity-draining and capital-consuming impact of new regulation and the extent to which bank-funding serves as a negative transmission channel for sovereign risk, the initially much-feared LCR now permits a broader pool of assets than originally proposed in 2009.

In addition to cash, central bank money and high-rated sovereign bonds, permissible assets in the LCR now include corporate debt rated A plus to triple-B minus, commercial paper and a select group of unencumbered equities and residential mortgage-backed securities, all subject to a haircut in the 25% to 50% range.

Banks’ stock prices rallied on the news that the Basle Committee had also extended the deadline for full LCR adoption by four years to 2019. In addition, banks will be allowed to run down their high-quality liquidity assets in the event of stress, endowing financial institutions with further flexibility in how they manage their buffers.

The more-flexible LCR is an unambiguous positive for corporate-heavy universal banks and UK financial institutions, such as Lloyds and RBS, that have adopted defensive liquidity positions in anticipation of new regulation, with wholesale funding more than adequately covered by short-term liquidity buffers, say Citi analysts. For banks’ shareholders and UK regulators the hope is that banks will now be encouraged to redeploy excess liquidity to boost lending and net interest margins, sell-side bank analysts conclude.

But the watered-down LCR proposal inevitably stoked the ire of reform critics, igniting the oft-touted charge of regulatory capture. "Yet again, the Basle Committee has demonstrated how it is practically impossible to reform the financial sector given diverging interests from the different governments, regulators and bankers," says Mayra Rodriguez Valladares, head of New York-based MRV Associates, which trains bank examiners and executives at financial firms. "The whole purpose of LCR is for banks to demonstrate that they have enough unencumbered, high-quality and liquid assets to help them in a time of real stress. Allowing RMBS, equities and corporate bonds even with a haircut only helps continue the pretence. A major part of Basle III is to include requirements that were not part of Basle II that really led to the crisis: lack of liquidity as well as excessive leverage."

In reality, the market consensus decrees that as far as capital and liquidity standards go, the rhetoric in favour of strong regulation has been met with overzealous action in recent years, both at the Basle level and through more exacting standards at the national level, such as the so-called Swiss finish and the UK’s stricter capital requirement with a 10% core tier 1 capital ratio (to be supplemented with an additional bail-in debt requirement). The softening of the liquidity stance, therefore, is the first sign of regulatory forbearance at the Basle level, balancing the health of the economy against the need to reform the financial sector, says Citi’s analysts.

Although populist critics argue that bank lobbying has succeeded in diluting the global liquidity standard, there is strong reason to suspect that central bankers themselves led the charge, given public pronouncements on profound risks emerging from the landmark LCR proposal: its potential to exacerbate the global collateral crunch and imperil bank-lending – by ring-fencing large amounts of bank reserves – combined with fears about its impact on central bank policymaking.

Mervyn King, Bank of England governor and chairman of the oversight body at Basle
Mervyn King, Bank of England governor and chairman of the oversight body at Basle
Even though the LCR is much less onerous than the Basle Committee initially pledged – and financial markets had expected – Mervyn King, Bank of England governor and chairman of the oversight body at Basle, signalled a desire for regulators to insulate themselves from blame for any associated cutback in lending. He said last month: "Since we attach great importance to try to make sure that banks can indeed finance a recovery, it does not make sense to impose a requirement on banks that might damage the recovery."

For Wayne Abernathy, executive vice-president for financial institutions policy and regulatory affairs at the American Bankers Association, the watering down of the liquidity rule and King’s pronouncement that most banks already conform to the new benchmark confirm a happy truth: the Basle III project is unravelling. "The shift in the LCR is not pro-bank or anti-bank. It is pro-reality," he says. "It looks like reality is now playing a role in shaping the rules at Basle."